Stagnation and inflation box in Fed
Public expectations can make inflation hard to contain.
The global threat called stagflation has grown in recent weeks and is putting the Federal Reserve in a box.Skip to next paragraph
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Ordinarily, America's central bank likes to set interest rates based on conditions at home.
But conditions "at home" – including the Fed's own monetary policy – are increasingly tied to global trends.
Economists say that's one reason why Fed Chairman Ben Bernanke this week voiced concern about inflation, and why financial markets are now factoring in the likelihood of a higher Federal Reserve interest rate by the end of the year.
It's not that the troubles within the US economy have gone away. The slowdown that has caused the Fed to cut interest rates in recent months could still turn into a recession. That stagnation puts the "stag" in "stagflation."
But the global inflation pressures – centered in commodity prices expected to drive the US inflation rate higher in a report Friday morning – haven't been cooling along with the US economy.
At a minimum, many economists say, this means the Fed has little leeway to cut its short-term interest further from its current level of 2 percent. And the Fed could even be forced into an unusual position of raising interest rates later this year, even while unemployment at home is rising.
"The important thing to recognize is that we are more interconnected financially with the rest of the world," says Tim Duy, an economist at the University of Oregon in Eugene. "The expectation ... was that oil prices were going to go down" as the US economy slowed, but that didn't happen, he says.
One reason is simply that the US, while still by far the world's largest single economy, is now counterbalanced somewhat by fast-rising emerging nations. Their continued strength has buoyed both the global economy and commodity prices.
But Mr. Duy says that another factor may be at work – an unintended consequence of the Fed's recent interest-rate cuts.
When the Fed eases monetary policy to stimulate growth at home, other nations with currencies pegged to the dollar also have to ease their monetary conditions in order to maintain their exchange rates. The result is more money in the global system, which translates into more upward pressure on oil, food, and other prices.
"That linkage of domestic policy having global impact [and then rippling back into US consumer prices] is new for the Federal Reserve," Duy says. "If it is true, I think it does represent a significant change."